A CASE STUDY IN TAXATION OF CORPORATE
LIQUIDATIONS
David C. Cummins*
The tax treatment regarding the sale of substantially all the assets
or of at least some of the most significant assets of a closely-held corporation, followed by the complete liquidation of the corporation and
receipt by the shareholders of both the proceeds of the sale and other
assets, is clear enough in the typical situation. Sections 336 and 337 of
the 1nternal Revenue Code' allow the corporation to obtain nonrecognition treatment of any gain in its liquidation. Section 331 gives the
shareholders exchange treatment on their receipt of the liquidating distributions, thus yielding capital gain treatment in the normal case. However, when the assets to be sold are those of a subsidiary corporation,
and the parent has other assets in addition to its stock in the subsidiary
corporation, the alternatives must be carefully explored if the shareholders of the closely-held parent corporation are to cash out their investment. The purpose of this case study is to explore those alternatives and
through that exploration to highlight the principal themes in the statutory structure of ~~ 331 through 337.
The Facts
Ace, an individual, owns all the stock of P Corporation which in
turn owns all the stock of S Corporation. P's only other asset is a parcel
of improved real estate held for the production of rental income. This
parcel is located in the City of Lubbock and the improvements have
been depreciated using the straight-line method of depreciation. S Corporation owns only some farm land in a suburban area just outside the
corporate boundaries of the City of Lubbock. Until recently S used this
farm land as a horse breeding farm and boarded horses for others. This
land has attracted some interest from Ken and Lon who are land developers and building contractors. There has also been some interest,
though less active, expressed by prospective purchasers in the improved
rental property owned by P.
Ken and Lon are willing to purchase S Corporation's property for
• Professor of Law, Texas Tech University: B.S., University of Idaho, 1957: J.D., University
of Washington, 1960: LL.M., New York University, 1969.
I. Unless otherwise indicated, all reference made in the text to section numbers is to sections
of INT. REV. CODE OF 1954. For the sake of brevity section numbers will be designated with the
section symbol (§).
659
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$250,000. $20,000 would be paid upon signing the contract and $30,000
on closing (within six months) with notes being given on closing for the
$200,000 balance payable over the next four years and secured by a
mortgage on the property. The contract would be contingent on the
buyer's obtaining (I) approval of a subdivision by the local planning and
zoning commission or other appropriate local authorities, (2) approval
of a soil test (for septic tanks) by the local board of health or other
appropriate local authorities, and (3) site approval by the Veterans
Administration and Federal Housing Administration. Closing would be
in six months or at such earlier time as such approvals are obtained. Ken
and Lon contemplate that the buyer would be X Corporation, which
would be organized by them. Ken and Lon would not be personaIly
liable on the contract obligations.
Assume that the rental property owned directly by P Corporation
would bring, if sold, $150,000 in the form of $50,000 cash down and a
$100,000 purchase money mortgage payable over five years. There is,
however, no immediate prospect willing to pay this price, and it may
take some time to find a purchaser.
An analysis of Ace's financial records discloses the following: his
basis in the P stock is $140,000; P's basis for its real estate is $70,000,
and its basis in the S stock is $78,000; S's basis for its land is $82,000;
P has earnings and profits of $50,000; and S has a deficit in earnings .
and profits of $80,000.
For the purposes of this problem, certain assumptions are made:
(1) The acquiring corporation, X, wiIl insist upon a basis for the
thing acquired equal to its fair market value.
(2) Ace not only wants top dollar for his assets and the lowest tax
liability, but he also wants an acceptable cash flow; i.e., a maximization
of the amount by which cash received in any taxable year exceeds taxes
due and payable in any taxable year.
(3) For the purpose of making computations in this case study,
no other income or deductions exist. Net additions to income from any
proposed solution will be the amount of taxable income upon which tax
is due.
The assumed hypothetical is represented by Figure 1 which appears
below.
With this hypothetical situation in mind, one can analyze various
alternative procedures to effect the disposition of the properties held in
the P and S Corporations.
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TAXATION: CORPORATE LIQUIDATIONS
661
Ace
fair market value $400,000
Stock
basis 140,000
fair market value $150,000
Earnings & Profits
$50,000
P
Rental Property
basis
70,000
fair market value $250,000
Stock
Earnings & Profits
basis
78,000
fair market value $250,000
S
Farm land
basis
82,000
($80,000)
(Figure I)
Alternative 1: (See figure 2.)
Step
Step #1
Ken
#2
Lon
Ace or Bank
'" '"
/'
// " debt
/'
Liquidation
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Step #3
Ken
Lon
Ace or Bank
Liquidation
Step #4
Ken
Ace.- or Bank
Lon
..- .-
..'-/cash and notes or assumption
Farm Land
~~
...:.<
Buyer
rental property
(Figure 2)
[n the first alternative, financing is obtained by X Corporation
through a third party such as a bank, and Ace sells his stock in P
Corporation to X Corporation for $400,000 cash. This yields a $260,000
long term capital gain. The § I tax is $74,090. (Section I is used because
it is less than the § 1201(b) alternative tax of $79,400.) The cash flow
would be $400,000 less the tax of $74,090 for a net flow of $325,910 in
the current year.
Alternative 2: (See figure 2.)
[f X Corporation cannot obtain financing through a third party,
Ace might sell his stock in P Corporation to X Corporation for a price
of $400,000 payable $80,000 in the current year and $80,000 in each of
four succeeding years. Section 453 allows Ace to report as income each
year only that portion of each installment that represents profit. Since
his basis in the stock is $140,000, and he has received $400,000,
260,000/400,000 or 65% of each payment would be reportable as a long
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TAXA nON: CORPORATE LIQUIDA nONS
663
term capital gain. 2 This gain of $52,000 each year would trigger a § I
tax of $7,590. The annual cash flow would be $72,410 ($80,000-$7,590
tax), and over a five-year period would be $362,050.
The buyer of the stock, X Corporation, could immediately liquidate P Corporation under § 332 (complete liquidation of subsidiaries)
and use § 334(b)(2) to obtain a substituted basis for the assets of P
Corporation which consist of the rental property and the stock in S. This
substituted basis is equal to X Corporation's basis in the stock of P
Corporation which was a cost basis under § 1012 of $400,000 (the fair
market value) whether X Corporation purchased for cash or for cash
and debt obligations. Under § 336 no gain is recognized to P Corporation on the event of its liquidation. Nor is any gain or loss recognized
to X Corporation on the liquidation of P because of § 332.3 X Corporation's basis in the acquired assets would be allocated according to the
fair market value of the assets received, yielding a basis of $250,000 in
the S stock and a basis of $150,000 in the rental property.
In order to obtain the farm land, X Corporation could then liquidate S Corporation as a subsidiary without recognition of gain either
to X, under § 332, or S, under § 336. But what is X Corporation's basis
in the farm land? Section 334(b)(2) will give X a substituted basis of
$250,000 in the farm land if X acquired the stock in S by a "purchase"
as required by § 334(b)(2)(B) and defined in § 334(b)(3). If not, X will
get a § 334(b)( I) carryover basis from S of $82,000 in the farm land. If
X does not receive a stepped-up basis in the property, equivalent to its
fair market value, then it should not enter into the transaction presented
by alternatives I and 2. Section 334(b)(3)(C) defines a "purchase" as
an acquisition of the stock in S only if that "stock is not acquired from
a person the ownership of whose stock would, under § 318(a), be attributed to the person acquiring such stock." The stock in S was acquired
from P Corporation as a liquidation distribution, and P's ownership of
the stock in S would be attributed to X Corporation as the sole owner
of stock in P under § 318(a)(2)(C). It would therefore appear that the
"purchase" requirement has not been satisfied, but the concluding sentence of § 334(b)(3) is forgiveness language and directly applies to this
transaction. Inserti ng the facts of the transaction into the statute, it
reads: " . . . the term 'purchase' also means an acquisition of stock [the
2. Throughout this case study the interest element in the installment payments will be
ignored.
3. There would not have been a realized gain or loss in any event since X's basis in the stock
of P Corporation ($400.000) would equal the amount realized in the liquidating distribution in the
form of the fair market value of the rental property and the stock in S Corporation.
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stock in S] from a corporation [P] when ownership of such stock
[ownership by P of the stock in S] would be attributed under § 318(a)
to the person acquiring such stock [X] if the stock of such corporation
by reason of which such ownership would be attributed [the stock in P]
was acquired by purchase [within the meaning of the preceding sentence]." Since the acquisition by X of the stock in P Corporation qualifies as a purchase under the three requirements of § 334(b)(3) subparagraphs (A), (B), and (C), the forgiveness language qualifies the transaction for the substituted basis of § 334(b)(2), and X Corporation will get
its desired basis in the farm land of $250,000. 4
A practical difficulty with either alternative 1 or 2 is that at the
current time there is no buyer for the rental property, and the burden
of disposing of the rental property, which X Corporation does not want,
is placed on the shoulders of X Corporation rather than on P Corporation or Ace. Presumably X would negotiate a reduction in the purchase
price for the stock in P if X were to assume this burden. The corollary
is that Ace's gain and cash flow would be reduced accordingly.
Alternative 3:
(See figure 3.)
In the third alternative, Ace liquidates P Corporation and receives
rental property and stock in S with total value of $400,000, a transaction
which yields a long term capital gain under § 331 of $260,000 and a § I
tax of $74,090. No gain is recognized to P Corporation under § 336, and
Ace acquires a basis in the rental property of $150,000 and a basis in
the stock in S of $250,000 under § 334(a). Ace can then sell his stock in
S to X Corporation for $250,000 cash if X obtains financing through a
third party, or for $250,000 payable $50,000 this year and $50,000 in
each of the next four years. Since Ace's basis would equal the amount
realized in the sale transaction, there would be no realized gain. If Ace
sold the stock in S for cash, his cash flow would be $250,000 less the
tax of $74,090 for a net of $175,910 in the year of liquidation and sale.
If Ace sold his stock in S for cash and notes, his cash flow in the current
year would be negative ($24,090) since his cash received of $50,000
would be less than his tax of $74,090. He would thereafter have a cash
flow of $50,000 in each of the next four years. The unfavorable cash
4. See Treas. Reg. § 1.334-I(c)(7)(iv) (1955) (examples 2 & 3 which are somewhat obtuse
but which support this conclusion:) Moreover, the judicial rule of Kimbell-Diamond Milling Co.
v. Commissioner, 187 F.2d 718 (5th Cir. 1951), allows a stepped-up to fair market value basis when
stock is acquired for the purpose of and as a means toward acquiring assets of the acquired
corporation.
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Step
TAXA nON: CORPORATE LIQUIDATIONS
#1
Step #2
Ace
Ace
~
liquidation
Step
665
q
cC Sh Or Lon
Ken
qSh~ nOte ~
StoCk'
S
In S
X
#3
Ken
Lon
Ace or Bank
Liquidation
(Figure 3)
flow in the first year might be moderated by currently selling the promissory note obligations of X Corporation, but that would presumably
have to be done at a discount.
An additional disadvantage is that Ace directly owns the rental
property previously owned by P Corporation. Ace will thus have rental
income included in his taxable income, and he will be exposed to the
rigors of direct operational management of the rental property and the
corollary potential of personal liability. This potential of liability may
expose other assets which Ace owns to the satisfaction of claims by
creditors of the rental property operation. A principal reason for incorporation is usually the limitation of the shareholder's entrepreneurial
risk to the amount of capital which is invested in the corporation. Furthermore, when Ace does later find a purchaser for the rental property,
he may have to sell on installments without a completed cash flow for
several years unless he discounts the purchaser's notes. Accordingly, this
alternative appears highly undesirable for Ace.
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X will liquidate S Corporation, without recognized gain to either
X, under ~ 332, or to S, under § 336. Section 334(b)(2) will give X a
substituted basis of $250,000 in the farm land ($250,000 having been X's
basis for the stock in S which X purchased from Ace). This result is
precisely what X Corporation desires, but § 381(a)(I) wil1 prevent the
deficit earnings and profits account of S from being carried over to X
where it might be used to offset future earnings of X. This disadvantage
might be avoided by not liquidating S Corporation. In that event X
could use it as a subsidiary corporation to subdivide and develop the
farm land into houses, apartments or other structures, and thereafter
distribute completed structures ready for sale to its parent corporation,
X. If that were done before any sales by S Corporation, the lack of any
positive earnings and profits account of S would mean that the distribution would not be a dividend when received by X. If X wants dividend
treatment and the dividends received deduction of ~ 243 (85% or 100%),
the distribution of the dividends could be delayed until S has sold some
of the lots or buildings. S would then have created some current earnings
and profits out of which the distribution to X could be characterized as
a dividend, notwithstanding the accumulated deficit earnings and
profits.
Alternative 4:
(See figure 3.)
The fourth alternative would be the same transaction as in the third
alternative except that Ace, at the time he liquidates P Corporation, will
make a valid § 333 election for a one month liquidation. Ace's realized
gain of $260,000 would be recognized only to the extent provided in
§ 333(e). He would receive dividend treatment to the extent of his share
of the earnings and profits (all $50,000 since he is the sole shareholder),
and the remaining $210,000 gain would be recognized to the extent that
the value of the stock in S exceeded the $50,000 that A recognized as
dividend income. 5 The value of the stock ($250,000) exceeds the dividend
by $200,000, and that amount would be long term capital gain under
§ 333(e)(2) thereby shielding only $10,000 of the realized gain ($260,000)
from current taxation. 6 Ace's basis for his stock in S and his rental
property would be $390,000 under § 334(c). It provides a substituted
basis for property received in liquidations equal to Ace's basis for the
stock in P ($140,000) plus any gain recognized in the liquidation. Ace's
5. [NT. REV. CODE OF 1954, § 333(e)(2).
6. If P had acquired the stock in S before 1954, Ace would have only a $50,000 dividend
upon which the § I tax would be $20,190. The remaining $210.000 would be nonrecognized gain.
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TAXATION: CORPORATE LIQUIDATIONS
667
basis for his stock in S and his rental property would be $190,000 under
§ 334(c). This basis would be allocated to the stock in S and the rental
property according to the value of those assets. Thus 250,000/400,000
(62.5%), times $190,000 ($118,750) would be Ace's basis in the stock in
S, and 150,000/400,000 (37.5%) times $190,000 ($71,250) would be
Ace's basis in the rental property.
Ace would then sell his stock in S Corporation to X Corporation
for $250,000 cash or for cash and notes, and this would yield a realized
and recognized long term capital gain of $131,250 and a § I tax of
$29,990. If the sale were for cash, Ace's cash flow would be $250,000
less the $20,190 tax on the $50,000 dividend and less the $29,990 tax on
the capital gain, for a net flow of $199,820. If Ace later sold the rental
property for $150,000, he would have a recognized long term capital gain
of $78,750 and a § I tax of $14,046.25. Ace could defer recognition of
gain on these two sales by selling under the installment method of § 453
and thus pay less tax each year at the lower graduated rates, but that
would mean that the cash flow would not be closed for five years.
A potential difficulty is that if Ace immediately sold the rental
property after the liquidation of P Corporation, it is possible that the
rationale of Commissioner v. Court Holding Co. 7 might apply to attribute the sale to P Corporation. Such an attribution would cause an
increase in P Corporation's earnings and profits by the amount of the
recognized gain on the sale, $80,000, less the § II corporate tax on that
amount. That increased earnings and profits would in turn cause an
increase in the amount of dividend treatment to Ace under § 333(e)(1).
Such a sale attributed to P Corporation would not be protected by § 337
because that section does not apply to elective one month liquidations
under § 33P
The tax consequences to X Corporation would be exactly as stated
in the third alternative.
Alternative 5:
(See figure 4.)
An unfavorable circumstance in alternatives 3 and 4 was that Ace
had direct ownership of the rental property. This might be avoided if
he sold 62.5% (i.e., $250,000 worth) of his stock in P to S Corporation
in return for the farm land. Ace would then sell this land to X Corpora-
7.
8.
324 U.S. 331 (1945).
See INT. REV. CODE
OF
1954, § 337(c)(1 )(B).
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[Vol. 5:659
Step #2
Step #1
Ace
62 1/2%
Stock in P
(Figure 4)
tion. If Ace could get long term capital gain treatment on the sale of
this part of his stock in P, the later sale of the farm land would take
place without any realized gain. The rental property would remain as
an asset of P Corporation until a purchaser was located.
However, this acquisition by the subsidiary of shares in the parent
corporation is treated as a redemption of the parent's stock under
§ 304(a)(2). Dividend equivalency is measured by Ace's ownership of
the stock of P and, under the attribution rules, Ace is the sole owner of
P both before and after the redemption, and so § 302(d) requires that
the distribution be treated as a § 301 distribution. 9 In determining the
amount of this distribution which is dividend, § 304(b)(2) treats the
distribution of the farm land as if it had been made by S to Ace through
P Corporation. Since such a distribution would not have been in complete liquidation of S Corporation, it would be a § 30 I distribution
yielding $172,000 ($250,000-$78,000) of long term capital gain for P
Corporation which would have increased its earnings and profits by that
amount, less the corporate tax on that amount. The result is that the
farm land distributed to Ace would have been largely a dividend, and
only a small portion would have been return of capital. Ace's basis for
his remaining stock in P would have been increased by the basis of the
surrendered stock in P less the portion of the redemption distribution
which was treated as a return of capital under § 301 (c)(2). Such substantial ordinary income treatment for Ace would be disastrous.
9.
Id.* 304(b)(I).
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TAXATION: CORPORATE LIQUIDATIONS
Alternative 6:
Step
669
(See figure 5.)
#1
#2
Step
A~
A~
Ken
cash or cash
+
<
Lon
note~ /
liquidation
~0
}.
Farm Land
Step
#3
Ace
Ace
Liquidation
~
or
liquidation
r~
\
p
cash
<
+ notes
rental property
~ Buyer
(Figure 5)
S Corporation could sell the farm land to X Corporation for
$250,000 cash or $250,000 cash and notes, after which S Corporation
would be liquidated. P Corporation could be liquidated, and Ace would
receive the cash, notes and rental property, or P could retain the rental
property until a buyer could be located for it, and the liquidation of P
could take place after a sale of the rental property. If S's sale of the
farm land is protected from any recognition of gain by the provisions
of § 337, and P's receipt of the proceeds is protected by § 332 from any
recognition of gain, then Ace will receive a liquidating distribution from
P either before or after sale of the rental property, undiminished by
corporate taxes.
However, while P will be protected from recognizing any gain upon
the receipt of the liquidating distribution from S Corporation under
§ 332, § 337 will not protect S Corporation from recognizing gain on
the sale of its farm land. S's realized gain of $168,000 ($250,000-$82,000
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TEXAS TECH LA W REVIEW
[Vol. 5:659
basis) will be recognized as long term capital gain because § 337 is not
applicable to sales by subsidiary corporations preceding a complete
liquidation of the subsidiary when the basis of the assets received by the
parent corporation is determined under § 334(b)(l) (the carryover
basis).IO S Corporation would bear a § 1201(a) alternative tax of
$50,400, and P Corporation would receive a liquidating distribution of
only $199,600 in cash or cash and notes. Upon later liquidation of P
Corporation, Ace would receive the $199,600 cash and notes plus either
$150,000 worth of rental property or $150,000 of cash and notes representing the proceeds of the sale of the rental property by P Corporation.
Ace's long term capital gain of $209,600 would yield a § 1 tax of
$56,450.
While the foregoing result, including taxation of S Corporation on
its sale, would literally follow from the statutory sections, and an IRS
Revenue Ruling so holds, two recent cases have concluded otherwise.
The lack of protection by § 337 was triggered because the sale preceded
the liquidation of a subsidiary under § 332, with the § 334(b)( 1) carryover basis rule operating to fix the basis in the hands of the parent
corporation. The theory of the two recent cases is that § 332 is applicable, and its corollary basis rule under § 334 is applicable, only when a
corporate tier (parent and subsidiary corporations) is abolished and the
corporate assets of the subsidiary are held afterward in corporate solution by a single (parent) corporation. The unifying nature of such a
corporate transaction is absent when both the subsidiary and the parent
are liquidated. In Kamis Engineering Co. v. Commissioner!1 the court
held § 332 inapplicable and afforded the protection of § 337 to the
subsidiary's sale when both the parent and the subsidiary corporations
were liquidated simultaneously. The court said: "Our conclusion that
§ 332 is not applicable where a simultaneous liquidation of both parent
and subsidiary is involved enables the respondent to extract one tax but
not two and accords with both the overall objective of § 337 and the
specific objective of § 337(c)(2)." A similar holding is contained in
Manilow v. United StatesY If these holdings, as yet not accepted by the
I RS, should be accepted by either the I RS or other courts, alternative
six appears to be a satisfactory one.
The taxation of Ace occurs upon the event of P's liquidation. No
opportunity for deferral of reporting of gain is available to Ace when
he receives the corporate liquidation distribution. However, if Ace were
10.
II.
12.
See id. § 337(c)(2); Rev. Rul. 172. 1969-1. CUM. BULL. 99.
60 T.e. 763 (1973).
315 F. Supp. 28 (N.D. III. 1970).
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TAXA TlON: CORPORA TE LIQUIDA TlONS
671
able to sell his stock in P Corporation prior to its liquidation, he could
gain the benefit of installment reporting under § 453. In Rushing v.
Commissioner,I3 the shareholders effectively sold their shares under the
installment method after the corporation had sold its primary asset
under § 337's protection but before the liquidating distribution was
made. The stock was sold to a bank in its capacity as trustee of an
irrevocable trust for the benefit of the shareholders' children. The court
found no constructive receipt by the shareholders of the liquidating
distribution and found no assignment of income by the shareholders.
Nor was the trustee-purchaser of the stock a straw man. Accordingly,
the court held in favor of the installment method reporting by the shareholders upon the sale of their stock. The effect of installment method
reporting of gain not only moderates the effect of the graduated rate
structure but also improves the cash flow.
Alternative 7:
(See figure 6.)
S could be liquidated and its assets distributed to P without recognition of gain to either S, under § 336, or to P, under § 332. P's former
basis in the stock of S, $78,000, would be lost, and P would take a
carryover basis in the farm land from S in the amount of $82,000. 14 P's
realized gain upon its sale of the farm land is unrecognized because it
is protected by § 337. Ace would then liquidate P and receive the proceeds of the sale of the farm land and the direct ownership of the rental
property without any reduction by reason of a tax at the corporate level.
However, the Court Holding Co. doctrine might apply to attribute
P's sale of the farm land to S Corporation. If S were deemed to be the
seller of its farm land, § 337 would not protect it from recognition of
gain, in the view of the IRS, under § 337(c)(2)(A).15 If that were true,
the same tax consequences as in alternative 6 would result. The taxpayer's argument as made in Kamis Engineering and Manilow would
be appropriate.
Those courts did not discuss a point which is raised by the current
alternative. Even if the sale of the farm land is not attributed to S
Corporation, is § 332 really applicable to protect P Corporation from
recognizing gain upon the event of its subsidiary's liquidation? As
pointed out in Kamis and Manilow, the purpose of § 332's nonrecognition of a parent corporation's gain is to allow tax-free continuation of
13.
14.
15.
441 F.2d 593 (5th Cir. 1971).
INT. REV. CODE OF 1954. § 334(b)(l).
See Rev. Rul. 172. 1969-1 CUM. BULL. 99 (Situation 4).
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TEXAS TECH LA W REVIEW
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Step #\
[Vol. 5:659
Step #2
Ace
A~
K~
~n
llaSh or cash + notes¥
[1]
Liquidation
Farm Land
>
Step #3
Ace
rI
Liquidation
\G
(Figure 6)
business in a unified corporate form. It is not to facilitate the winding
up process, a purpose served by § 337 but limited to the forgiveness of
tax upon corporate sales of assets preceding the winding up process.
Under this reasoning, § 332 might not be applicable, and P Corporation
would thus recognize its $\72,000 long term capital gain upon receipt
of the liquidating distribution from S Corporation, yielding a § \201 (a)
alternative tax of $5\ ,600. Since P Corporation would then have a fair
market value basis for the farm land, it would realize no gain upon the
later sale of the farm land. In this posture Ace would receive in liquidation the $250,000 of sales proceeds plus $150,000 worth of rental property less P's tax of $5\ ,600, and thus Ace would have a $208,400 long
term capital gain and a § \ tax of $56,030. If P's sale were for cash and
notes, Ace's cash flow would be negative in the year of sale and liquidation.
Alternative 8:
(See figure 7.)
The classic illustration of § 337 would find P Corporation selling
both its assets, viz. the stock in S and the rental property, within the
l2-month period following the adoption of a plan of complete liquidation. P Corporation is fully protected from recognized gain on the sales
HeinOnline -- 5 Tex. Tech L. Rev. 672 (1973-1974)
TAXATION: CORPORATE LIQUIDATIONS
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Step #1
Ace
cash or cash
Buyer
673
+
notes
)
""'-<~--------­
stock in S
rental property
Step #3
Step #2
Ace
Liquidation
~
Ken
Lon
Ace or Bank
/
. / / debt
/
/
Liquidation
(Figure 7)
under § 337 and on the liquidation distributions under § 336. X Corporation can liquidate S Corporation and thereby obtain the farm land
without recognition of gain under § 332. X's basis in the farm land
would be a § 334(b)(2) substituted basis equal to X's cost basis for its
stock in S; i.e.. $250,000. Ace would receive $400,000 of cash or cash
and notes yielding a $260,000 long term capital gain and a § I tax of
$74, 090. If P's sales were for cash, then Ace's cash flow would be
$325,910 and fully closed in the year of liquidation. IfP's sales were for
cash and notes, Ace's cash flow in the year of liquidation would be
$50,000 from the sale of the stock in Sand $50,000 from the sale of the
rental property, less his tax of $74,090, for a net flow in that year of
$25,910. The cash flow would be $70,000 in each of the next four years
and $20,000 in the fifth year. Alternatively, Ace might discount and sell
his $300,000 of notes and close out his cash flow in the year of liquidation. Should Ace adopt the Rushing technique of selling his stock in P
Corporation prior to the liquidation distribution, Ace could qualify for
§ 453 installment method reporting of his gain and achieve an even
better cash flow.
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TEXAS TECH LAW REVIEW
674
Step #1
[Vol. 5:659
Step #2
Ace
Ace
~
Stock in S
Step #3
Ken
Lon
Ace or Bank
;
liquidation
Step #4
Ace sells the stock in P or
liquidates P and sells the
rental" property.
(Figure 8)
It should be noticed that whether or not P Corporation sells it
assets under the installment method, P Corporation is protected from
recognizing any gain. Section 337 is fully applicable to the sales, and
the general rule of recognition upon distribution by P of an installment
obligation under § 453(d)(I) is not operable because of § 453(d)(4)(B).
The sale of the rental property could be made during the same 12month period as the sale of the stock in S Corporation. The initial
contract to sell the stock in S will be conditioned on X's obtaining
suitable zoning and government approvals, and the contract will not be
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TAXA TlON: CORPORATE LIQUIDA TlONS
675
closed for approximately six months. The plan of complete liquidation
will be adopted immediately prior to closing. This timing will allow
approximately 18 months in which to find a purchaser for the rental
property. This delayed adoption of the plan of complete liquidation
would be supported, if attacked by the IRS, on the grounds that more
than one-third of the assets of P Corporation consists of the rental
property which may be sold if a purchaser is found, but may be retained
as a corporate asset if a purchaser is not found. Only upon actual
adoption of the plan is it clear for the first time that the rental property
will either be sold by the corporation or distributed in liquidation.
Alternative 9:
(See figure 8.)
P Corporation could spin off the stock in S Corporation to Ace,
who would then sell the stock in S Corporation to X Corporation. In
the year following the spinoff and sale of the S stock, Ace would either
sell the stock in P Corporation or liquidate P Corporation and sell the
rental property.
This spin off does not qualify under § 355 for nonrecognition treatment because the § 355(b)( I )(A) active business requirement is not satisfied since S Corporation is not actively engaged in a business immediately after the stock distribution. In addition, § 355(a)(I)(B)'s device
clause is triggered because of the prearranged plan of Ace to sell the
stock in the spun off corporation. Accordingly, the distribution of the
stock in S is treated as a § 30 I distribution yielding a $50,000 dividend,
$140,000 reduction in Ace's basis in the stock of P Corporation, and
$60,000 long term capital gain. Ace would have a $250,000 basis in the
stock in S and thus no realized gain upon his rather immediate sale of
that stock to X Corporation. Ace's alternative tax at the time of the spin
off would be $35,960, and Ace would have a $150,000 long term capital
gain upon his later sale of the stock in P or upon the later liquidation
of P and a corollary $36,120 tax. If Ace sold the two blocks of stock
for cash in successive years, his cash flow would be:
Year #1
$250,000
35,960
$214,040
Year #2
$150,000
- 36, t 20
$113,880
for a total net flow of $327,920. If both sales were for cash and notes
but were in the same successive years, his cash flow would be:
HeinOnline -- 5 Tex. Tech L. Rev. 675 (1973-1974)
TEXAS TECH LA W REVIEW
676
Year
#1
#2
#3
#4
#5
#6
#7
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$14,040
92,810
67,910
67,910
67,910
17,910
17,910
$346,400
The favorable results to Ace in this alternative appear because of the
rather low amount of earnings and profits of P Corporation and the
rather high amount of Ace's basis in his stock in P Corporation. If those
characteristics were not present, this alternative would not be so favorable. An important advantage is that the rental property is held as a
corporate asset until the time when its sale occurs.
A possible difficulty is that under the Court Holding Co. doctrine
the sale by Ace of the stock in S Corporation might be attributed to P
Corporation. P Corporation could gain no protection under § 337 unless a plan of complete liquidation had previously been created and was
later carried out. Without § 337 the sale by P Corporation would be
taxable, and the receipt by Ace of cash or cash and notes would be
treated as a partial liquidation distribution under § 346, and would yield
exchange treatment and recognized gain under § 331.
CONCLUSION
The foregoing alternatives do not exhaust the possibilities but they
illustrate the methodology that is necessary when dealing with this type
of problem. The wide disparities in tax liabilities and cash flow are in
themselves sufficient to warrant the expenditure of effort in analyzing
various alternatives. Nor is that effort wasted (much less unbilled) if Ace
responds that perhaps he won't cash out his investment but will go into
the land development business with Ken and Lon. Such a response only
creates a need for a new set of alternatives.
HeinOnline -- 5 Tex. Tech L. Rev. 676 (1973-1974)